[By Praveen Sharma & Sakshi Nalawade]
The authors are students of Maharashtra National Law University, Mumbai.
On 8th July 2022, the Securities Exchange Board of India (SEBI) released a consultation paper seeking the opinion & comments of the public on its desire to extend the scope of SEBI Prohibition of Insider Trading (PIT Regulations), 2015 to include the dealings in the units of mutual funds. It is vital to take note of the fact that this move has come after the Axis Mutual Fund Front Running Controversy and Franklin Templeton case. In this blog, the authors argue that this move by SEBI might be too hard on mutual funds. While the issue needs immediate attention, simply putting mutual funds under the umbrella of PIT Regulations could be onerous for the mutual fund industry
Background
Currently, the PIT Regulations regulate dealings in securities of listed companies or proposed to be listed, when in possession of Unpublished Price Sensitive Information (UPSI) and it explicitly excludes the transactions in mutual funds. The objective sought to be fulfilled is to harmonize the regulations governing trading in securities and mutual funds, while one is in possession of UPSI.
There have been instances wherein officials from the mutual funds’ investment regulating the industry, for instance, employees of Asset Management Companies (AMC(s)) and Trustees of mutual funds have redeemed their holdings in mutual funds schemes being privy to Price Sensitive Information not made public i.e., information not known to the unit holders. Thus, by taking undue advantage of their position they either saved themselves from loss or incurred huge profits. In the Axis Bank Front Running controversy, two of the executives were sacked by Axis Mutual Fund on the accusation of front-running. This resulted in a huge blow to the market as the fund was 7th largest mutual fund in India and such instances at a large fund definitely bought out the lacuna in the mutual fund industry. The case of Franklin Templeton primarily further might have triggered this harmonization by the SEBI. Vivek Kudva, head of Franklin Templeton’s Asia Pacific, an International Asset Management Company, and his wife Roopa Kudva withdrew an investment of Rs. 30.70 crores from six debt funds of the company before they were shut for redemption. This withdrawal was after it was decided to wind up these six debt schemes as they were not performing well and before the actual date of winding up. Kudva also redeemed his mother’s investment from these schemes. Accordingly, he saved himself and his family members from loss in MF by using UPSI.
The Proposal by SEBI
The paper has defined the terms ‘Insider’, ‘Connected Person’, and ‘Designated Persons’ concerning mutual fund transactions and has laid down conditions to which these people will be subjected while dealing in mutual fund schemes. Essentially, the person coming under the purview of ‘Designated Persons’, their ‘immediate relative’, and ‘any person from whom such designated person takes trading decisions’ must report their trading of mutual fund units to the Compliance Officer. Further, AMC will disclose their details of holdings in the units of mutual funds on an independent platform as specified by SEBI quarterly. In addition, during the ‘Closure Period,’ a period during which the above-mentioned people can reasonably be expected to have possession of UPSI will be entirely restricted from dealing in the mutual fund units. And when such a closure period is not applicable, they are to take a pre-clearance from the compliance officer to make transactions. It defines UPSI as any information about a scheme of a mutual fund that is not yet generally available and which could materially impact the Net Asset Value or materially affect the interest of unit holders, certain instances of the same have been particularly mentioned.
Analysing the move
While it is certain that SEBI is strengthening itself when it comes to market regulation and is being as precise as possible. With the SEBI circular already covering insider trading provisions, this move is an extra attempt by SEBI to curb insider trading. SEBI has previously imposed limitations on fund managers and staff members of AMCs for dealing in the securities market through several circulars. At first, there were only restrictions on trading listed securities, but in 2021, through a circular dated October 28, 2021, employees, AMC directors, trustee board members, and access persons (as defined in the said Circular) were also forbidden from engaging in any scheme while in possession of certain sensitive information. It is possible to argue that SEBI’s recent decision to include mutual funds under the ambit of the Insider Trading Regulations is nothing more than an effort to greatly consolidate the previously existing regulation. But this action is unprecedented and unethical (disproportionate).
As correctly pointed out by Mr. Sandeep Parekh (Securities Lawyer and Ex-ED at SEBI), in ET blog, SEBI in its paper seeks to add ‘two new classes of people under the ‘connected persons’ category namely, the people working with the mutual fund executives like lawyers and research analysts and unconnected people trying to avoid insider trading allegations by dealing in mutual funds like judges and accounting firms. He correctly brings out the lacuna in this process as it further complicates the enforcement process for SEBI. For the former, just doing their jobs would make them a connected person, further, if they invest in that company’s shares having no access to any UPSI and it happens to make good quarterly numbers, this will open them to criminal charges. Accordingly, years after their association with any mutual fund deal, they might face allegations associated with it and might be put in a position where they must rebut the ‘presumption of guilt’ so formed. Additionally, the definition of UPSI includes many instances of routine changes which would make any piece of information affecting daily transactions in mutual fund sensitive information. Following this, every person who has some knowledge about the routine changes such as ‘change in accounting policy’, which are not even material and has relations with an MF executive or a Fund house will have to face restrictive measures to invest and bear the fear of being incriminated. Any remote and irrelevant act will make one a ‘connected’ person. Apart from this, there are cases wherein the person might be connected and so, had access to UPSI but did not avail it, still, as per Regulation 2(h) of the PIT Regulations, such persons would be deemed to be ‘insiders’ by the virtue of their connection and a presumption of them being guilty would be formed. The deemed insiders will have to rebut the presumption of guilt and prove their honest ‘intent’ and ‘effect’ concerning that transaction which is extremely difficult. The same has been substantiated in Mrs. Chandrakala v. SEBI. The latter category of people just by the virtue of their position become ‘connected’ people and must face restrictive measures while dealing with MFs. Further, the deeming provision in the Regulation is onerous in nature, as has been explained above.
The standards and parameters of proving innocence are immensely high and failure to meet these would result in a pang of presumed rebuttable guilt. Thus, making it extremely difficult for these people to invest in any scheme. Following this, the evidential burden keeps shifting on the accused. Further, this procedure is violative of the accused person’s ‘Right to Silence’ which has been enshrined in Article 20(3) of the Indian Constitution. The accused person’s Constitutional right to remain silent until proven guilty gets violated.
SEBI’s Slip-on Front-Running
Insider Trading is when a person holding a significant position in the company trades in that company’s securities while being privy to certain UPSI and uses this information to make the trade. The person in such a position breaches his fiduciary duty towards the company and its shareholders as he knowingly uses the UPSI to deal in that company’s securities.
On the other hand, the concept of front running is generally understood as intermediary or non-intermediary, wherein the person privy to UPSI trades ahead of his client or passes on the information to a third party, and that party places trades ahead of this person’s client. In both scenarios, the person holding UPSI breaches his fiduciary duty towards that client.
In the above-discussed instances, people falling under the definition of ‘Insider’, ‘Connected Person’, or ‘Designated Persons’ used UPSI to exit from MF schemes and unethically saved themselves from huge losses. They undermined the ethical standards and good faith while dealing in MF schemes and caused a breach of their fiduciary duty towards the clients. This is not a case of insider trading because in insider trading the insiders deal in the securities of that company while being privy to UPSI which has not happened in the instant case. Here, withdrawals from MF schemes have taken place while being privy to UPSI. Dealing in the securities of a company and withdrawing from a mutual fund scheme are two entirely different concepts, from different investment fields of the capital market having separate procedures. Usage of UPSI in both does not make them the same malpractice.
Further, front running has no one definition, as has been laid down in the landmark judgment of SEBI v. Shri Kanaiyalal Baldevbhai Patel, Supreme Court made it crystal clear that fraud broadly consists of unfair trade practice that undermines the ethical standards and good faith dealings between the parties engaged in that business transaction. But these practices are not subject to a single definition. Accordingly, front running does fall under the above-described definition of fraud, thus, it is not to be subjected to its widely accepted definition of intermediary or non-intermediary.
It is for the courts to define “Front running” from time to time whenever the opportunity presents itself, but little has been done apart from the above-mentioned case. Whenever an opportunity presents itself, the court should delve into the nuances of what front running is, what it could be, its types, and the parameters to determine all the above.
Concluding Remarks
While the reaction of the market regulator after the Axis Mutual Fund Controversy and Franklin saga was expected, SEBI could have further tightened the front-running laws. Front-running is covered only under Regulation 4(2)(q) of SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) 2003. The authors believe that further strengthening of front-running laws could have been a more efficient step by the market regulator. It is also vital to note that PIT Regulations are aimed toward regulated listed securities and not pooled investment vehicles. The issue of unfair trade practices in mutual funds could have been curbed through internal checks and balances. As an alternative, the market regulator can suggest a stronger internal control mechanism for mutual funds, such as adopting CAQ Guide on Internal Control, which would be largely efficient in addressing the not-so-common instances of insider trading in mutual funds. With the mutual fund industry already crossing Rs. 37 trillion in Asset Under Management (AUM), this move of SEBI could hamper growth of the mutual funds industry. It is expected of the market regulator that it would not hamper the growth of the mutual fund industry through stricter and rather unrequired laws especially when it had the alternative of strengthening the front-running laws